Liquidation Threshold

Thresholds are set based on asset volatility and liquidity.

• Stablecoins (USDC, DAI): High thresholds (75-85%) due to low price volatility.
• Major Cryptos (ETH, WBTC): Moderate thresholds (70-82%) reflecting higher volatility.
• Liquid Staking Tokens (stETH): Slightly lower thresholds (~70%) due to derivative and potential depeg risk.
• Long-Tail / Altcoin Assets: Much lower thresholds (40-60%) due to extreme volatility and lower liquidity.

Liquidation thresholds are enforced using real-time price data from oracles (e.g., Chainlink). The accuracy and latency of these feeds are critical. A price deviation or stale data can cause premature or delayed liquidations. Protocols often use a safety margin (a buffer below the official threshold) in their internal calculations and may implement circuit breakers to pause liquidations during extreme market volatility or oracle failure.

The Liquidation Threshold is the collateral asset value, expressed as a percentage of the borrowed asset value, at which a position becomes undercollateralized and can be liquidated. It is a protocol-set parameter, distinct from the Loan-to-Value (LTV) ratio used for initial borrowing. For example, if ETH has an 80% threshold, a position is liquidatable when the value of the borrowed assets reaches 80% of the collateral's value.

These are two distinct but related risk parameters that create a safety buffer.

• Loan-to-Value (LTV): The maximum you can borrow initially (e.g., 75% for ETH).
• Liquidation Threshold: The point where your loan is at risk (e.g., 80% for ETH). The difference between them (e.g., 5%) is the liquidation buffer or safety margin. This buffer gives users time to add collateral or repay debt before a price drop triggers liquidation.

When a position's Health Factor falls below 1.0 (meaning debt value exceeds the liquidation threshold), it becomes eligible for liquidation. The process involves:

• A liquidator repays part or all of the user's outstanding debt.
• In return, they receive the user's collateral at a liquidation bonus (a discount).
• The protocol may charge an additional liquidation penalty to the borrower, which is paid to the protocol's treasury or reserve fund. This penalty makes the effective loss for the borrower greater than just the price decline.

Borrowers must monitor several dynamic factors to avoid liquidation:

• Asset Volatility: Sudden price drops in collateral or spikes in borrowed asset value can rapidly erode the safety buffer.
• Protocol Parameter Updates: Governance can vote to change liquidation thresholds, potentially making existing positions riskier.
• Health Factor Monitoring: This real-time metric (Total Collateral in ETH / Total Borrowed in ETH) must be tracked. A Health Factor approaching 1.0 signals imminent risk.
• Gas Costs & Network Congestion: During market volatility, high gas fees can delay or prevent preventative actions like adding collateral.

Prudent users employ several strategies to manage liquidation risk:

• Conservative Borrowing: Borrow significantly less than the maximum LTV to create a larger safety buffer.
• Diversified Collateral: Using a basket of less-correlated assets can reduce portfolio volatility.
• Automated Monitoring & Alerts: Using tools to track Health Factors and set price alerts for key levels.
• Over-collateralization: Deliberately depositing more collateral than required to withstand larger market swings.
• Understanding Asset-Specific Risks: Knowing which assets in your portfolio have lower thresholds (higher risk) and adjusting accordingly.

From a protocol perspective, the liquidation threshold is a lever for managing systemic risk.

• Setting Thresholds: Protocols must balance user flexibility (higher thresholds) with system safety (lower thresholds). Stablecoins typically have higher thresholds than volatile assets.
• Liquidation Incentives: The liquidation bonus must be sufficient to incentivize liquidators to act as a decentralized risk management layer, especially during high gas fee environments.
• Cascading Liquidations: In extreme volatility, a wave of liquidations can drive down collateral prices, potentially triggering more liquidations—a feedback loop known as a liquidation spiral. Robust threshold settings and liquidation mechanisms aim to prevent this.

The Loan-to-Value (LTV) ratio is the initial risk parameter set when a loan is opened, representing the maximum amount that can be borrowed against a specific collateral asset. It's calculated as (Borrowed Amount / Collateral Value) * 100%. A lower LTV indicates a safer, more conservative position. This is the starting point; as the collateral value fluctuates, the Health Factor determines the actual risk of liquidation.

The Health Factor (HF) is a dynamic, real-time metric that measures the safety of a borrowed position. It is calculated as (Collateral Value * Liquidation Threshold) / Total Borrowed Value. A health factor above 1.0 is considered safe. When the HF drops below 1.0, the position becomes undercollateralized and can be liquidated. It is the primary trigger mechanism, directly influenced by both the Liquidation Threshold and market price movements.

The Liquidation Bonus (or discount) is an incentive offered to liquidators for participating in the liquidation process. When a position is liquidated, the liquidator can purchase the borrower's collateral at a price below the market value—for example, at a 5% discount. This bonus compensates the liquidator for their work and market risk, ensuring the system remains solvent. The size of the bonus is a key protocol parameter affecting liquidation profitability.

Maximum LTV is a protocol-level parameter that defines the absolute ceiling for borrowing against a specific collateral type. It is the highest Loan-to-Value (LTV) ratio allowed when initially opening a position. For instance, if ETH has a Maximum LTV of 80%, a user cannot borrow more than $0.80 for every $1.00 of ETH deposited. This is a critical risk control, set lower than the Liquidation Threshold to create a safety buffer.

Collateral Factor is a term synonymous with Liquidation Threshold used primarily in lending protocols like Compound. It defines the percentage of a deposited asset's value that can be borrowed against. For example, a collateral factor of 75% means that for every $100 of deposited asset, a user can borrow up to $75 worth of other assets. Exceeding this utilization makes the position eligible for liquidation.

A Liquidation Call is the specific transaction executed by a liquidator to close an undercollateralized position. This process typically involves repaying part or all of the borrower's debt in exchange for a proportional amount of their collateral, often at a Liquidation Bonus. Successful calls restore the protocol's solvency by ensuring all loans are over-collateralized. These calls are permissionless and are a core component of decentralized lending's economic security.